The Gains from Trade Why do people specialize

The Gains from Trade Why do people specialize in the production of a few goods or services and then trade? Why don't people become self-sufficient instead, producing everything they need? Comparative advantage 1

An Example Suppose there are two people, Mc. Pherson and Brown. Both can produce Tacos and Spaghetti, but they are not equally adept. Comparative advantage 2

Mc. Pherson's Daily Production Possibilities tacos 5 10 Comparative advantage spaghetti 3

Mc. Pherson has preferences that make him want to consume 4 tacos and 2 spaghetti. [Show his consumption point on the graph. ] Comparative advantage 4

Brown's Daily Production Possibilities tacos 12 Brown 5 Mc. Pherson 10 Comparative advantage 12 spaghetti 5

Suppose that Brown consumes 5 spaghetti and 7 tacos. [Show his consumption point on the graph. ] Comparative advantage 6

Without specialization and trade here's where they are in production and consumption: Brown Mc. Pherson S 5 2 T 7 4 Total 7 11 Comparative advantage 7

Absolute advantage: A person has an absolute advantage in the production of a good if he/she uses less inputs to produce a unit of the good. Notice that Brown has an "absolute advantage" in the production of both goods. Comparative advantage 8

Comparative advantage: A person has a comparative advantage in the production of a good if that person can produce an extra unit of the good at lower opportunity cost. Comparative advantage 9

Be sure you can answer these questions: 1) What's Mc. Pherson's cost of one more plate of spaghetti? 2) What's Brown's cost of one more plate of spaghetti? 3) Who has the "comparative advantage" in spaghetti production? Go to hidden slide Comparative advantage 10

Now let Mc. Pherson specialize completely in the production of spaghetti, and Brown specialize completely in the production of tacos. Comparative advantage 12

The table shows total production with specialization. More is produced of both goods. Brown Mc. Pherson S 0 10 T 12 0 Total 10 12 Comparative advantage 13

If Brown and Mc. Pherson can arrange to specialize and then trade, both can be better off. In this case the gains from specialization are 3 plates of spaghetti and 1 taco. Comparative advantage 14

The Krugman Example The Krugman example of comparative advantage starts with input requirements instead of output limits. But the two are really equivalent. Comparative advantage 15

The table shows labor requirements per vehicle. What’s the MC of a bus? AUTO BUS EAST 100 200 WEST 600 300 Comparative advantage 16

Suppose each area had 3, 000 hours total labor. Then EAST could produce 30 AUTOS, or 15 BUSES. Or any combination in between. And WEST could produce 5 AUTOS, or 10 BUSES. Or any combination in between. Comparative advantage 18

AUTOS 30 MC of a BUS in the East is 2. MC of a BUS in the West is 0. 5. EAST WEST 5 10 Comparative advantage 15 BUSES 19